The LTWM Insider – Market and Economic Commentary Q2 2022

Executive Summary 

It was another challenging quarter for investment portfolios, both stocks and bonds were down together for the second quarter in a row. For the U.S. markets, the Federal Reserve Board of Governors (the Fed) delivered a higher than expected 75 basis point (0.75%) increase to the overnight lending rate at its June meeting and signaled another 50-75 bps increase at its next meeting on July 27th. The Fed has delivered strong actions to slow the economy in its attempt to control inflation. The Fed started its $8.9 trillion balance sheet reduction (selling bonds) ramping up to a rate of $95 billion per month in September or $1.1 trillion annually; and so far, this move has met fierce buying from the flight to quality bond traders. Many bond market buyers believe the Fed tightening will send the U.S. economy into recession; but they could still lose capital if interest rates continue to climb.

Together, both Fed moves have already shifted the entire yield curve up and are having a slowing effect on the U.S. economy. The Fed really needs to bring inflation down quickly to help those living paycheck to paycheck. The average consumer is still spending, but at the lowest end, consumers are restricting purchases to rent, food and gas, which is hurting small business owners. Commodity prices are now down 20% from their highs in June, but there are many games being played with the supply of energy around the globe and the price of crude and natural gas remains elevated. Higher mortgage rates are cooling the housing market, which was very much needed to keep housing and rent affordable.

The last S&P 500 peak was on January 5th, we are about 145 days into the current correction, which includes stocks, bonds, real estate, bitcoin, and gold. The asset classes and stocks with the highest valuations are down the most, value stocks are down the least. LTWM portfolios have a sizeable value bias. We are witnessing an outlier event, with bonds down so much at the same time as stocks. And with outlier events, there is usually a sharp reversal. We can’t tell you when it will be, but the best way to capture it is to remain invested. During the last quarter, we made two fixed income investment changes to shorten duration and the potential for bond losses from rising interest rates (see below for more details). We remain cautiously optimistic on the strength of the American consumer to make it through the period of higher inflation and believe better returns are in the future for globally diversified portfolios with a value and size bias. We also know we’re in a period of high volatility that will likely be with us for the foreseeable future.

Research suggests, the best way to take advantage of high volatility is to monitor portfolios more often to take advantage of rebalancing opportunities and continue to make retirement plan contributions. We are currently monitoring portfolios weekly for 20% asset drift from target, so if, for example, the asset class U.S. Large Cap Value has a portfolio target weight of 10%, and declines 20% to make the portfolio weight 8%, we purchase a 2% position to bring the weight back to its 10% target. We would like to remind everyone that you don’t own the highs and you don’t own the lows, you own the long-term performance of your portfolio. The best course of action is to focus on the decisions you can control to achieve the success of your financial plan. We are here to support your continued success and would be happy to answer any questions or concerns.

For those who would like a deeper dive into the details, please continue reading…

World Asset Class 2nd Quarter 2022 Index Returns

U.S., International Developed, and Global Real Estate stocks were all down in the second quarter, following the negative short-term momentum from the first quarter. U.S. and Global Bonds were also down as the level of interest rates increased on short and longer maturities. For the broad U.S. Stock Market, the first quarter return of -16.7% was well below the average of 2.2% since January 2001. International Developed Stocks returned -14.66%, which was below the long-term average quarterly return of 1.4%. Global Real Estate Stocks returned -17.22%, well below the asset class’s average quarterly return of 2.3%.  Emerging Market Stocks returned -11.45%, below the average quarterly return of 2.6%. While supply chains have improved, production is still an issue, and higher inflation persists. The Federal Reserve has started selling its bond holdings and continues to signal rate increases of 50 to 75 basis points. This increased economic uncertainty and restrictive Fed policy sent stocks down for the quarter. Here is a look at broad asset class returns over the past year and longer time periods (annualized):

As June 30th, 2022, Global Real Estate stocks (as defined by the S&P Global REIT Index) led all categories by declining the least, down -10.61% in the last year. The U.S stock market (as defined by the Russell 3000 Index) lost -13.87%, while International Developed stocks lost -16.76% during the past year. Emerging Market stocks lagged with a one-year return of -25.28%. Over the past five years, U.S. stocks were up 10.6% annually, while International Developed stocks were up 2.66% annually, Emerging Market stocks were up 2.18% annually, and Global Real Estate stocks were up 2.79% annually. Over the past 10 years, the U.S. stock market (up 12.57% annually) is well ahead of International Developed (up 5.37% annually) and Emerging Market (EM) stocks, which are up 3.06% annually over the past 10 years. We continue to believe EM might be the place to be for the next 10 years, but so far, the asset class continues to underperform. During the second quarter, the dollar was very strong, which hurts international returns.

Taking a closer look within U.S. stocks in the first quarter, we can see that market wide results were down -16.7%, while value overwhelmingly outperformed growth across large and small cap stocks. Large Value stocks were ahead of Large Growth stocks by more than 8% and Small Value stocks beat Small Growth stocks by about 4%. Overall, small cap stocks slightly underperformed large cap stocks during the second quarter of 2022

If we extend our analysis of U.S. stock over longer time periods, large growth is no longer the leading asset class over the past 1 year, but still leads over 3, 5 and 10 years. Large Value stocks are now in the lead for the past year and small value stocks are second best. The lofty valuations of growth stocks are coming back to earth. It is worth noting that Market wide results for the past 10 years are still strong, up 12.57% annually.

International Developed Stocks were negative in local currency, and more negative in US dollars, since the dollar appreciated against most foreign currencies. In July, the Euro is near parity with the U.S. dollar, down from $1.18 one year ago, which makes travel to Europe more popular for U.S. citizens this summer. The value premium (value-growth) was very large, while the size premium was negative (small cap stocks underperformed large cap stocks). The currency effect served as a headwind to international stock returns during the quarter, as US currency returns were lower than local currency returns. Our investment funds are priced in U.S. dollars and the dollar’s strength from the first quarter continues through the second quarter.

Value was better than growth in the last quarter and the last year for International Developed Stocks. Over longer time periods, the value premium (value-growth) is negative for the past 3, 5 and 10 years. The size factor premium (small cap-large cap) is now negative in the past quarter and year, but it is positive over the past 3 and 10 years. There is still plenty of room for value to catch growth over longer time periods in the future.

The U.S. economy is still moving forward in a new post-Covid business cycle, but slowing quickly with a Fed that has promised to prioritize price control over maximum employment. It is a difficult but necessary task, since higher prices is an extra burden on all households and hurts those living paycheck to paycheck the most. It may feel like a recession has already started for lower income households and small business owners. However, in the aggregate, the average wage earner is doing well; and jobs are still plentiful. The U.S. job market remains very tight; and is likely to support the current business cycle expansion.

Shifting the commentary to fixed income, bond market returns around the world were negative during the second quarter, due to a sizeable increase at the short end of the curve, as the Fed lifts the overnight lending, with more increases expected this year. The yield on the 5-year Treasury note increased by 59 basis points, ending the quarter at a yield of 3.01%. The yield on the 10-year Treasury note increased by 66 basis points, ending the quarter at a yield of 2.98%. And the 30-year Treasury bond yield increased by 70 bps to 3.14%. Here is the U.S. yield curve, and you can see how yields jumped at the short end to make the curve flat from 2 years out to 30 years (current yield curve in grey, one quarter ago in blue, and one year ago in green):

LTWM acted in response to the expected increase in rates. We made the decision on April 22nd to sell and limit the losses in our most conservative fixed income asset class and replace it with the money market, since rising short term rates improves the yield on the money market and its par value of $1 does not lose money when short-term rates increase. Then on May 5th, we sold our highest duration fixed income holding, which had a duration of 6 and replaced it with zero duration USFR, an ETF that invests in floating rate U.S. Treasury Bills, which increase in value with higher interest rates. Both decisions were made to ensure we are following the philosophy of a stable reserve for fixed income. The stable reserve is used to rebalance out of when stocks decline. We have not yet reached a rebalance point where we would sell bonds and buy stocks, but some asset classes are close. The two steps were meant to protect portfolios from the large losses of longer maturity bonds.

Notice below, the highest first quarter and only positive bond return is for the US 3-Month Treasury Bill Index, while the US Government Bond Index Long was down 11.89% for the quarter. The most positive index over the last year is now the US 3-Month Treasury Bill Index, which was up 0.17% for the past year. Over longer periods, the best returns are still with High Yield Corporate Bonds, due to the strong performing U.S. economy in the past decade. Here are the period returns:

On June 15th, the Fed raised its benchmark lending rate by 75 basis points to 1.75%, which was the most aggressive hike since 1994; and signaled another rate increase of 50 or 75 bps at its next meeting on July 27th. The Fed has also started quantitative tightening (selling bonds) at a rate of $50 billion a month for June, July and August; and then increasing to $95 billion a month staring in September, which is designed to raise interest rates at the long end. Currently the Fed balance sheet is at $8.9 trillion, so it will take years to normalize its portfolio of bonds. The latest CPI report had the highest inflation in 40 years, up 9.1% for June and now the probability of a full 1% rate hike from the Fed went from 0.14% to 14% at its next meeting in July.

One cannot time markets and typically the short term is just noise. Here is a sample of how the world stock markets responded to headline news, during the last quarter and the last year (notice the insert of the second graph that compares the last 12 months to the long term). We encourage you to tune out the financial news, since major news sources have a bias toward negative headlines; and often the headlines of the day have very little to do with the direction of stocks.

CONCLUSION

We would also like to share a timely piece from our friends at Dimensional on how to weather the stock market’s storm:

Three Crucial Lessons for Weathering the Stock Market’s Storm

Marlena Lee, PhD

Global Head of Investment Solutions

Investors can always expect uncertainty. While volatile periods like the one we’re experiencing now can be intense, investors who learn to embrace uncertainty may often triumph in the long run. Reacting to down markets is a good way to derail progress made toward reaching your financial goals.

Here are three lessons to keep in mind during periods of volatility that can help you stick to your well-built plan. And if you don’t have a plan, there’s a suggestion for that too.

1. A recession is not a reason to sell

Are we headed into a recession? A century of economic cycles teaches us we may well be in one before economists make that call.

But one of the best predictors of the economy is the stock market itself. Markets tend to fall in advance of recessions and start climbing earlier than the economy does. As the below shows, returns have often been positive while in a recession.

All the dots in the upper left quadrant in the chart below are years where the US economy contracted but US stocks still outperformed less-risky Treasury bills. It’s a great illustration of the forward-looking nature of markets. If you’re worried, other investors are too, and that uncertainty is reflected in stock prices.

Whether accompanied by recessions or not, market downturns can be unsettling. But over the past century, US stocks have averaged positive returns over one-year, three-year, and five-year periods following a steep decline.

A year after the S&P 500 crossed into bear market territory (a 20% fall from the market’s previous peak), it rebounded by about 20% on average. And after five years, the S&P 500 averaged returns over 70%.1

We believe that staying invested puts you in the best position to capture the recovery. If you take risk out of your portfolio, it should be a strategic, not tactical, choice. We believe the only good reason to sell out of a stock portfolio now—so long as it’s diversified and low-cost—is because you learned something about your risk-tolerance or your investment goals have changed.

2. Time the market at your peril

When stocks have declined, it might be tempting to sell to stem further losses. You might think, “I’ll sit out until things get a bit better.” But by the time markets are less volatile, you’ll have often missed part of the recovery. Yes, it stings to watch your portfolio shrink, but imagine how you’ll feel when it’s stuck while the market rebounds.

Big return days are hard to predict, and you really don't want to miss them. If you invested $1,000 in the S&P 500 continuously from the beginning of 1990 through the end of 2020, you would have $20,451. If you missed the single best day, you’d only have $18,329—and only $12,917 if you missed the best five days.2

History shows the stock market tends to rebound quickly. The same can’t be said for individual stocks or even entire sectors. (How many railroad stocks do you own?) So, while investing means taking on some risk for expected reward, investors should mitigate risks where they can. Diversification is a top risk mitigation tool, along with investing in fixed income and having a financial plan.

3. It may be a good time to reassess your portfolio and your plan

We saw many fads crop up through the pandemic, from baking to puppy adoption. Did you experiment with one of the pandemic investment fads—FAANGs or meme stocks or dogecoin? If so, it may be time to put those fads in the rearview.

Do you know the names of all the stocks you own? Then you probably own too few. How much of your portfolio sits outside the US? Because about half the global market is comprised of foreign stocks. If you only invest in the S&P 500, you’re missing half of the investment opportunity set. A market-cap-weighted global portfolio is a better starting point than chasing segments of the market that have outperformed in the past few years.

And if you want to outperform the market, allow decades of academic research to light the way. Portfolios focused on small caps, value stocks, and more profitable companies have had higher returns over the long run. The portfolio I use is invested across more than 10,000 global equities in over 40 countries.

Beyond a well-designed portfolio, one of the best ways to deal with volatile markets and disappointing returns is to have planned for them. A financial advisor can help you develop a plan that bakes in the chances you’ll experience some market lows. And they can help you find the confidence to weather the current storm and get to the other side.

A sound approach to investing—through a plan, a well-designed portfolio, and an advisor—is the ultimate self-care during these rough markets. Your future self will thank you

This piece first appeared in MarketWatch with the title
“Follow these 3 crucial lessons for weathering the stock market’s storm.”

1. S&P data © 2022 S&P Dow Jones Indices LLC, a division of S&P Global. All rights reserved. Indices are not available for direct investment.

2. Past performance, including hypothetical performance, is no guarantee of future results. Growth of $1,000 is hypothetical and assumes reinvestment of income and no transaction costs or taxes. The analysis is for illustrative purposes only and is not indicative of any investment. S&P data © 2022 S&P Dow Jones Indices LLC, a division of S&P Global. All rights reserved. Indices are not available for direct investment.

Diversification neither assures a profit nor guarantees against loss in a declining market. Past performance is not a guarantee of future results.

The information in this material is intended for the recipient’s background information and use only. It is provided in good faith and without any warranty or representation as to accuracy or completeness. Information and opinions presented in this material have been obtained or derived from sources believed by Dimensional to be reliable and Dimensional has reasonable grounds to believe that all factual information herein is true as at the date of this material. It does not constitute investment advice, recommendation, or an offer of any services or products for sale and is not intended to provide a sufficient basis on which to make an investment decision. Before acting on any information in this document, you should consider whether it is suitable for your particular circumstances and, if appropriate, seek professional advice. It is the responsibility of any persons wishing to make a purchase to inform themselves of and observe all applicable laws and regulations. Unauthorized reproduction or transmitting of this material is strictly prohibited. Dimensional accepts no responsibility for loss arising from the use of the information contained herein.

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 Standardized Performance Data and Disclosures

Russell data © Russell Investment Group 1995-2020, all rights reserved. Dow Jones data provided by Dow Jones Indexes. MSCI data copyright MSCI 2020, all rights reserved. S&P data provided by Standard & Poor’s Index Services Group. The BofA Merrill Lynch Indices are used with permission; © 2020 Merrill Lynch, Pierce, Fenner & Smith Inc.; all rights reserved. Citigroup bond indices copyright 2020 by Citigroup. Barclays data provided by Barclays Bank PLC. Indices are not available for direct investment; their performance does not reflect the expenses associated with the management of an actual portfolio.

Past performance is no guarantee of future results. This information is provided for educational purposes only and should not be considered investment advice or a solicitation to buy or sell securities.  Diversification does not guarantee investment returns and does not eliminate the risk of loss.  

Investing risks include loss of principal and fluctuating value. Small cap securities are subject to greater volatility than those in other asset categories. International investing involves special risks such as currency fluctuation and political instability. Investing in emerging markets may accentuate these risks. Sector-specific investments can also increase these risks.

Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed-income investments are subject to various other risks including changes in credit quality, liquidity, prepayments, and other factors. REIT risks include changes in real estate values and property taxes, interest rates, cash flow of underlying real estate assets, supply and demand, and the management skill and creditworthiness of the issuer.

Principal Risks:

The principal risks of investing may include one or more of the following: market risk, small companies risk, risk of concentrating in the real estate industry, foreign securities risk and currencies risk, emerging markets risk, banking concentration risk, foreign government debt risk, interest rate risk, risk of investing for inflation protection, credit risk, risk of municipal securities, derivatives risk, securities lending risk, call risk, liquidity risk, income risk. Value investment risk. Investing strategy risk. To more fully understand the risks related to investment in the funds, investors should read each fund’s prospectus.

Investments in foreign issuers are subject to certain considerations that are not associated with investment in US public companies. Investment in the International Equity, Emerging Markets Equity and the Global Fixed Income Portfolios and Indices will be denominated in foreign currencies. Changes in the relative value of these foreign currencies and the US dollar, therefore, will affect the value of investments in the Portfolios. However, the Global Fixed Income Portfolios and Indices may utilize forward currency contracts to attempt to protect against uncertainty in the level of future currency rates (if applicable), to hedge against fluctuations in currency exchange rates or to transfer balances from one currency to another. Foreign Securities prices may decline or fluctuate because of (a) economic or political actions of foreign governments, and/or (b) less regulated or liquid securities markets.

The Real Estate Indices are each concentrated in the real estate industry. The exclusive focus by Real Estate Securities Portfolios on the real estate industry will cause the Real Estate Securities Portfolios to be exposed to the general risks of direct real estate ownership. The value of securities in the real estate industry can be affected by changes in real estate values and rental income, property taxes, and tax and regulatory requirements. Also, the value of securities in the real estate industry may decline with changes in interest rate. Investing in REITS and REIT-like entities involves certain unique risks in addition to those risks associated with investing in the real estate industry in general. REITS and REIT-like entities are dependent upon management skill, may not be diversified, and are subject to heavy cash flow dependency and self-liquidations. REITS and REIT-like entities also are subject to the possibility of failing to qualify for tax free pass through of income. Also, many foreign REIT-like entities are deemed for tax purposes as passive foreign investment companies (PFICs), which could result in the receipt of taxable dividends to shareholders at an unfavorable tax rate. Also, because REITS and REIT-like entities typically are invested in a limited number of projects or in a particular market segment, these entities are more susceptible to adverse developments affecting a single project or market segment than more broadly diversified investments. The performance of Real Estate Securities Portfolios may be materially different from the broad equity market.

Fixed Income Portfolios:

The net asset value of a fund that invests in fixed income securities will fluctuate when interest rates rise. An investor can lose principal value investing in a fixed income fund during a rising interest rate environment. The Portfolio may also be affected by: call risk, which is the risk that during periods of falling interest rates, a bond issuer will call or repay a higher-yielding bond before its maturity date; credit risk, which is the risk that a bond issuer will fail to pay interest and principal in a timely manner.

Risk of Banking Concentration:

Focus on the banking industry would link the performance of the short-term fixed income indices to changes in performance of the banking industry generally. For example, a change in the market’s perception of the riskiness of banks compared to non-banks would cause the Portfolio’s values to fluctuate.

The material is solely for informational purposes and shall not constitute an offer to sell or the solicitation to buy securities.  The opinions expressed herein represent the current, good faith views of Lake Tahoe Wealth Management, Inc. (LTWM) as of the date indicated and are provided for limited purposes, are not definitive investment advice, and should not be relied on as such.  The information presented in this presentation has been developed internally and/or obtained from sources believed to be reliable; however, LTWM does not guarantee the accuracy, adequacy or completeness of such information. 

Predictions, opinions, and other information contained in this presentation are subject to change continually and without notice of any kind and may no longer be true after the date indicated. Any forward-looking statements speak only as of the date they are made, and LTWM assumes no duty to and does not undertake to update forward-looking statements.  Forward-looking statements are subject to numerous assumptions, risks and uncertainties, which change over time.  Actual results could differ materially from those anticipated in forward looking statements. No investment strategy can guarantee performance results. All investments are subject to investment risk, including loss of principal invested.

Lake Tahoe Wealth Management, Inc.is a Registered Investment Advisory Firm with the Securities Exchange Commission.